SFB 303 Discussion Paper No. B - 048
Author: Sondermann, Dieter
Title: Currency Options: Hedging and Social Value
Abstract: In this paper I shall first present a brief outline of the theory of hedging on non-redundant contingent
claims as required for the hedging of currency options. We then will address another problem with the pricing
and hedging of currency options, i.e. the stochastic volatility of the underlying security price process. Only if this
volatility is constant over the hedging period and known in advance, the option would be theoretically redundant
in the sense of Hakansson. But whenever the estimate is different from the true volatility the option is no longer
attainable even in the simple Black-Scholes model and thus non-redundant. Moreover, in particular the volatility
of foreign exchange rates show significant random fluctuations, thus moving currency options far away from
being attainable. Finally we discuss the effects of currency options and their hedging on the volatility of the
foreign exchange markets and their role in the allocation on individual and social exchange risks. We conclude
with some recommendations of how to use these financial instruments for central bank interventions in order to
smooth exchange rate movements.
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Creation-Date: August 1986
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